Commodities

We have been researching the Commodity sector over the last year as it is clearly primal to the economic changes in the East.

As Asia develops its infrastructure and as the populations move from the Countryside to the Cities (with growing demand for a higher standard of living) this process will involve the consumption of basic commodities.

Using the primary economic analysis of “supply & demand” it stands to reason that with billions of people demanding a finite supply this must and will cause prices to rise.

We are under noting bullet points to the various commodity sectors as a starting point to understanding supply / demand relationship.

Basic Concept

• Commodities are part of our everyday lives and crucial to modern existence
• When stocks and bonds are doing down and inflation is heading higher, commodity prices tend to move up
• China is the key to understanding commodity demand
• With interest rates in US government bonds at multi-decade lows, there’s nowhere for bond prices to go but down (i.e. as interest rates rise the capital values fall)
• Commodity returns are similar to those of equities, but commodity returns are not well correlated to those of stocks or bonds, making an ideal addition to most portfolios
• Owning your own oil field, mine or farm is one way to get direct physical exposure to commodities, but it just isn’t practical for most people

How they are traded

• The price of a given futures contract will always converge to the “spot”, or cash market price at expiration, but a lot can happen between the dates when futures contracts begin and expire
• During the 1980s and 1990s, the futures curve for most commodities was downward sloping (backwardation), yet commodity funds were posting excellent results since they were able to buy low and sell high
• Most stock indices are constructed and weighted according to the market capitalisation of their components. In commodities, however, the concept of market capitalisation doesn’t apply
• Commodity indices are often poor barometers for gauging activity levels in commodities
• Commodity-producing companies offer leverage to rising commodity prices and the opportunity to benefit from reserve additions over time

Energy

• No commodity is more visible, important, controversial, or crucial to our modern way of life than oil
• Publicly listed energy companies control just 15 percent of the world’s known oil reserves
• With the world’s existing oil fields tired and in decline, the industry will face the monumental task of finding vast, economically viable new reserves to exploit over the next few decades
• To hold global oil production at 2008 levels, the industry needs to find supply equal to that currently produced by Iran – each month and every year
• The IEA predicts that between now and 2030, the lion’s share of demand (93 percent) will be driven by non-OECD countries, with China and India alone accounting for 53 percent of this figure
• A perfect storm of slumping global supplies, voracious demand, and increasingly hostile host governments has made it difficult for Big Oil to grow their reserve bases
• Despite major advances in the industry over the last century, more than two-thirds of all oil still gets left in the ground after a field is deemed uneconomic to continue with
• Companies with long-lived oil reserves in countries with low political risk should be the go-to investments for those looking to pump up their profits
• Refiners and integrated oil and gas companies will continue to be laggards for the foreseeable future, as low margins in the refining business continues to act as a damper on stock prices
• By combining horizontal drilling and hydraulic fracking techniques, massive new gas fields will be developed – a  step change for the natural gas business
• There is a surplus of natural gas in North America, which has depressed gas prices
• Natural gas prices are more volatile than oil prices
• Somewhat between 50 to 80 percent of the variability in natural gas prices can be explained by the weather. This relationship is stronger in the winter months
• Oil prices have become decoupled from natural gas prices and historical trading ratio of 6:1 no longer applies
• When the natural gas prices recover, the best bets for investment are likely to be in the service companies that specialise in horizontal drilling and reservoir fracking, and in the producers that specialise in developing the so-called unconventional gas reservoirs

Precious metals

• Gold and other precious metals often outperform stocks, real estate and bonds when banks are under stress, the US dollar is weak, and inflation is running rampant
• Gold last peaked in 1980 at $850 per ounce, the inflation adjusted equivalent of $2,189 per ounce
• Nearly 90 percent of known gold, with an approximate value of $4.5 trillion, has already been mined
• An investment in an ETF offers direct exposure to a financial interest in stockpiles of physical gold at a fraction of the cost of holding your own stash
• Silver does best when gold is performing well and industrial activity is high
• South Africa mines almost 76 percent of the world’s platinum, most of which is turned into jewellery and catalytic converters for cars
• Russia is the largest producer of palladium, a metal with similar end-markets to platinum

Industrial metals

• Commodity prices for hot rolled steel, copper, aluminium, and zinc are the first to move when global industrial production begins to accelerate
• It takes at least five years and big bucks to get a mine up and running and into full production once economically viable quantities of copper, nickel or zinc have been discovered
• China is the 800 pound gorilla of commodity consumption, accounting for nearly 100 percent of global demand growth for copper during the 2007 bull market in industrial metals
• Globally, about one billion people live on a dollar a day – the benchmark for extreme poverty

Soft commodities (foodstuffs)

• Half the world’s grain harvest is fed to livestock, and it’s expected that by 2030 another billion metric tons of cereal per year will be required to meet human and animal needs
• From 1961 to 2005, food production increased at 10 times the rate that arable land became available, as a result of improved agricultural practices
• With rising incomes, a shift is occurring toward grain – and water intensive meat-based diets
• Farm commercialisation will be the single biggest factor driving the next decade of growth in agriculture
• Fertilised crops grow 30 to 50 percent faster than unfertilized crops – giving commercial farms a huge leg up on their small scale competition
• Commercial fertilizers act as plant food, delivering various forms of the three critical nutrients (nitrogen, potassium and phosphate)
• The introduction of GM seeds is altering the competitive dynamic for farmers
• Shifting debts and economic growth in the developing world are behind a general rise in the prices of most grains
• Corn and soybeans are the big cash crops grown in America, with wheat a distant third
• Rice is the world’s second largest staple crop. America produces less than 2 percent of the world’s rice and exports nearly half of its production – accounting for 10 percent of the global rice trade
• The grains markets are amongst the smallest of all commodity markets, a situation that can sometimes distort prices. Only 20 percent of the world’s wheat production is traded and only 7 percent of rice production is exported, let along exchange traded
• Grains are not only a profitable investment niche to exploit on their own, they also act as a leading indicator for fertilizer investments
• A growing world population and changing diets will underpin strong demand for grains
• Grains are among the least cyclical of all commodities because eating is something we all need to do

Bulk commodities

• Steel, an important industrial pillar that supports prestige industries, is produced the world over
• Steel can be made in either an electric arc furnace (using scrap steel) or in a basic oxygen furnace (using raw materials), which produces a higher quality end product
• China produces more steel than Brazil, Russia, Ukraine, Germany, India, South Korea, and the United States combined
• Iron is the world’s most commonly used metal, with 98 percent of all iron ore earmarked for steelmaking
• Coal is the fastest growing fossil fuel of the last century. The Asia Pacific region accounts for 90 percent of its demand growth
• If shipping rates are on the rise, investors should increase their exposure to bulk commodities such as coal, iron ore, and steel, which are all moved internationally by sea
• To keep tabs on global shipping rates, the Baltic Dry Index (BDI) is your best guide
• Unlike most other commodities, iron ore and coal don’t have a futures contract for investors to trade

Conclusion

• The underlying trend is undeniable: Asia, led by China, is on an upward economic trajectory
• As Chinese and Indian consumers cross the income thresholds at which cars and other big-ticket items become affordable, they will be the spark to ignite the commodity price rally

NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.